Exelon's Big Gamble

When it comes to energy, there are surprising differences in the views of different stakeholders. Representatives from various energy companies often argue that their source is better and that other sources should be discounted. Within the power sector, pro-nuclear experts often argue against natural gas or coal. Other power producers argue that renewable energy is better than fossil fuels. Still others just love natural gas.

For investors, it can become confusing. They want to understand where the opportunities lurk and where rhetoric obfuscates challenges -- but they may find that the markets provide them with some important clues.

In the power industry, which uses a variety of fuels, most utilities turn on their power plants in some logical order. It doesn't matter if generating assets are regulated or deregulated; power plants are normally turned on ("dispatched") in order of production cost. The lowest-cost unit is dispatched before the next-most-costly unit until enough generation is available to meet the grid's demand.

Of course, there are exceptions. Some plants are designated as "must-run" in order to keep the grid balanced and stable. Other plants, such as large-coal and nuclear, will often run out of economic order because it is too costly for their owners to switch their plants on and off, then back on again.

For investors focused in the power industry, a helpful tool is the "aggregate supply curve." For simplicity, I'm going to call this tool the "price-takers curve."

The price-takers curve represents what analysts expect see when they look at a regional transmission organizations (RTO) or independent system operators. 10 of these RTOs operate across the U.S.

The curve illustrates the point of view of the market, which tends to be agnostic toward the sources of energy. That is, the market doesn't care if the power source is fueled from natural gas, nuclear, coal or oil. It needs energy, and electricity is fungible -- and, as long as the generator provides the energy, the market is satisfied.

The market usually behaves as expected. As system-wide demand for power increases, more generation is needed to meet that demand -- and, as demand increases, so do prices. In turn, as those prices rise, uneconomic resources become economic, they take the price and they begin generating.

On the generators' side, meanwhile, attempts are made to take the market price only when it's above their production cost. If they produce power below their production cost, they lose cash, having paid more for fuel than they've received for energy. They subsidize the market, and they hurt their competitors by displacing them uneconomically.

The point of view of nuclear-power-plant owners is illustrated by the silver bars. Their production costs vary by owner, but they range between $17.80 and $27.10 per megawatt hour, according to the Nuclear Energy Institute.

In the price-takers curve above, if the grid's demand exceeds 85,000 megawatts, nuclear plants take higher prices, they have enough revenue to cover other costs and they'll perhaps make a profit. But if grid demand falls below 80,000 megawatts, market prices fall below nuclear production costs, and if nuclear plants continue operating, they will lose real money.

In 2012, the average market price for "load-weighted energy" fell almost 30% year over year to $35.02 per megawatt hour, according to PJM Interconnection. While that average price exceeds production costs and provides an average nuclear plant with gross margin, the margin is not enough to cover all its costs.

The challenge for Exelon (EXC) is highlighted by this curve and PJM's report. Most of this company's generating plants are nuclear. It operates in a merchant fleet, it is subject to market prices and it cannot find high enough prices needed to operate profitably. Exelon is gambling that the market and margins will each show improvement.

Dominion Resources (D) decided not to take the gamble -- it looked into the future and decided to exit one RTO and remain in another. The company recently announced its decision to retire and decommission a single-unit nuclear plant, which competes with Exelon plants in the same RTO.

Dominion owns two nuclear facilities in regulated markets. While the dispatching principles are the same, the economics are not. Regulated plants are cost-plus enterprises, and they do not rely on markets for their revenue.

This is why nuclear plants in the southeastern and northwestern states are profitable: They are regulated and they are not price-takers.

My next column will analyze the price-takers curve in more detail. It particular, it will discuss why Exelon's future may be a big gamble, but that the markets could reward risk, particularly if the risk-taker is patient.